Boston's vibrant downtown and quality of life issues loom large in this city's turnaround success story.

Q: Let's start with a look at Boston's employment base, since that helps to define the users of the market's office space.

Guilliaem (Rusty) Aertsen: Looking at Boston, you can't ignore the impact of the mutual fund industry. Sixty percent of the purchasing power in the industry is here in Boston. Beyond the mutual funds you have a huge number of private capital investors that are here. When you couple that with high-tech and biotech which is principally in the suburbs, you've got the largest part of the growth in Eastern Massachusetts, which really drives all of New England inside of 495.

Kevin McCall: In '91 or '92 Michael Porter from Harvard Business School wrote his Competitive Advantage of Massachusetts paper and identified the industries that Rusty just talked about, he also added on healthcare, which has a lot of curiosity about it, and is a major source of economic drive in this state, particularly in the Eastern part of the state. The fourth that he identified was knowledge, and by that he meant the educational institutions and consulting firms.

One thing he didn't identify but gets a lot of play in the press is tourism. That certainly has an impact on such things as a convention center for Boston, and the hotel market in Boston has really come flying back and now there are something like 13 to 15 new hotels that are being talked about or actually underway in the Greater Boston area, which will slightly overbuild that market.

Robert Perriello: One of the things we look at as an office company is the office-using employment growth, the finance, insurance, real estate service, the users of the space which highly correlates. If you look at Boston, during the last three years has ranked anywhere from fourth to eighth among all of the top 50 metropolitan areas in terms of growth in the office-using sector, anywhere from 20,000 to 30,000 jobs depending on what trailing 12 months you look at. So while people look at the Northeast as a low-growth area in terms of employment, if you look at the sector that we're interested in, it's really among the top tier.

Boston Roundtable Participants

Guilliaem (Rusty) Aertsen

Group Executive, Real Estate Capital Markets

Bank of Boston

Tom Collins

Managing Director, New England

Cushman & Wakefield

David Fitzgerald

Senior Vice President/Partner

Whittier Partners

Stewart Forbes

President

Colliers International

Robert Griffin

Principal

Fallon Hines & O'Connor

Mahmood Malihi

President

Leggat McCall Properties

Kevin McCall

Director, Real Estate Equity

Aldrich Eastman Waltch

Robert Perriello

Executive Vice President, CFO

Beacon Properties

Picking up on what Kevin said, the knowledge base, there's a lot of qualitative fundamentals here -- the universities, the quality of life here is incredible -- so that for people to come in and say, `We're moving this company' or Fidelity to say, `All you analysts are going to Rhode Island,' some of those folks would say, `We're not going to Rhode Island because we like to live here in Boston.' So I think the quality of life here presents a factor that you don't find in very many downtowns.

If you look at the software companies alone, the number of companies has doubled in the past five years, and the employment is probably 140% of what it was five years ago, and just because of the MIT and Harvard spin-offs, people like it here, they stay, they start these companies and that's been a big generator of demand in Cambridge.

Q: In other major cities, there has been a trend of tenants leaving the core downtown and migrating to the suburbs. Has there been a certain amount of urban flight here in Boston?

Perriello: I don't think we've seen hardly any trade between either leaving here to the suburbs or coming back. Two examples I can think of was the accounting firm that moved to the Wellesley Office Park from downtown 22 years ago, and moved back downtown. and you had Cabot Corp. move from here (downtown) to the suburbs and then three years ago back downtown.

Mahmood Malihi: In general, the migration is more from Cambridge, but I haven't seen anything that shows a trend to moving outside the city.

Tom Collins: You also see the spread between the rents in the suburbs and the rents downtown are really closing. There's not a big price differential in the suburbs. Vacancy rates in Cambridge are under 5% and the suburbs are under 8% and downtown is under 8%. There is a lot of upward pressure on rents. The investor market -- everybody in the world would like to invest in Boston. And you're not getting any real new construction on a speculative basis because nobody's ready to do that yet, but you're also not seeing a lot of build-to-suits because the primary drivers are tenants that are not financeable. Fidelity is a big credit company and a big user, but they want to be able to leave that space after two years, four years, six years, eight years. No one's going to finance that. And then there's the 2,200 software companies that this week are in 1,200 sq. ft. and next week they'll want to be in 5,000 sq. ft. And then you're in the market looking for 100,000 sq. ft. and a month later you're going to sublet 50,000 sq. ft. of that, so there's that roller coaster ride and you end up with a tremendous amount of demand and our numbers show that we've absorbed about 1.3 million sq. ft. this year already in a very tight market overall.

Malihi: Yesterday I saw a presentation on the correlation between commuting time to wages to a large extent is a much bigger factor in running the business than the rent is. In a city like Boston with the infrastructure we have, with the subway system we have and with the pool of residents within the city, I think that logic is less significant here than in the Atlantas or Dallases of the world. It's a 24-hour city, you've got people living in the city, you've got a spoke and hub system with the ability to bring people via public transportation into the city is a different dynamic than cities that are built on strictly edge cities.

Aertsen: You have a core downtown area which is Boston, but then you have a surround of residential neighborhoods really extending to the near suburbs, so you have a city that doesn't empty out at night and come back in during the day, so the dynamic here is completely different than in a lot of other cities. The only other one that might be comparable to us is San Francisco. You're seeing that in the fact that there's a lot of new construction now underway or planned for, residential as opposed to office, where you still have to deal with the rents being lower from an actual market rate than the replacement cost of the new office buildings assuming you can get financing for it. But that's not true in residential.

Stewart Forbes: How much of a trend are people seeing where companies are doing the same with substantially less space? Now you're seeing the revenues still trying to escalate but they're doing it with less space. Is there a shrinkage going on in Boston?

Aertsen: I think you can have growth in companies without having necessarily growth in space. It's one thing when you rent and you still have space to absorb, but everyone's very cost conscious today, particularly in the mutual fund industry. As rents get to a certain point, in addition to finding other locations to do some of that, with non-core downtown essential space moving out to lower-cost location, some of it not even in New England, you're going to have smaller office cubicles, where square feet per employee will drop, hoteling, there will be huge changes that may impact up to 20% to 30% of the available square feet that a company uses. In many ways that's just beginning. There's been a lot of talk about it, but one of the things we look at is when the A space gets into the $30 range, will they get to $45 a foot driven by basically one industry. Will they allow that to happen, or will they recognize what's going on and find ways to adjust. You still have this huge cyclical spike, but I think in the long run things have to start to settle down, and that 20% to 30% efficiency factor will loom very large going forward.

Q: Is there actually a reduction of space or a spreading of the use?

Perriello: From a human factor, just think of it, you call ahead and say, `Alright I'm going to be in the office today.' They move the pictures of your family in there and tomorrow they move it out for somebody else. We do not see that to be a significant factor because you do have the human element. People don't like it.

Malihi: I tend to agree with that.

Perriello: It's overrated, it's over-talked about, we've had fax machines for 20 years. You've had a lot of high technology. People still need to congregate. They need to be in offices. Can there be a reduction in the square foot per person? Sure, but I would disagree that it's going to be 20%. I just think you do have the human factor.

Collins: The technology's all in place, which is why everybody talks about it and it's sort of a dreamland of how you can go from 230 sq. ft. per employee to 108, but the fact of the matter is that the management of these corporations has not developed to the point where you can figure it out. I mean brokers, do we need to be in the office every day? We don't. If my brokers are out in the field they're probably making money for me which is the same with Arthur Anderson. Their audit people ought to be out in their customers' offices doing their audit. Do they need to come back to a central place to do their report? No, not with the technology today. But how many people can actually work that way? How many people have the discipline to work at home? The companies that are trying this are struggling with the management philosophies. It's an experiment, and I don't think we know the answer yet.

Malihi: The Fortune 500 labor force has been reduced by 60%. Just look at our tenant mix. The same universe of square footage, just a fragmentation of Corporate America. The dynamics of the small tenants are totally different than the large ones. If anything we're seeing the larger tenants shrinking in size, becoming more efficient, but the growth is coming more from the smaller tenants.

Forbes: One of the things that comes as a result of fragmentation is the business community does not have the same leadership position in effecting change within the city that it used to have. Because leaders are different. You used to have institutions, but that doesn't exist in the same way. What typically has developed a city is a merging of interests where the political community and the business community have been able to cooperate. I don't know what the percent is of Boston to that level of cooperation vis a vis other cities, but the city is awfully strong right now. Five years ago people said the high cost of living was going to drive people out and that doesn't seem to be a factor anymore.

Malihi: As the baby boomers come up the pyramid, there's only room for so many to be at the top of the pyramid. The demographics will force them to set up their own firms.

McCall: If you look at other cities around the country, Boston has a pretty good public/private partnership environment. As a new generation of leadership takes over which has a somewhat more evolving view of the benefits to a company of creating a good infrastructure in the urban areas, then I think you'll see more interaction for a positive result. I think they're in a period of flux now driven largely by the drive to efficiency and earnings.

We benefit from not really needing to have a strong government role, which is fortunate because the government hasn't really provided a lot of leadership in terms of attracting new businesses to Massachusetts, very fragmented in terms of how you identify it. There hasn't been a need, with 5% vacancies across the markets.

Malihi: The economics of this region is really not conducive to bringing people in. The combination of the educational institutions, the healthcare and the venture capital is very explosive in creating new companies, but we can't get people to come in. This is not the cheap place to run a business.

Collins: All of the stuff that's been done to make this city has been done in the last four decades.

Perriello: The other thing too is the infrastructure that's going in place. The harbor cleanup, the third harbour tunnel, putting the elevated highway and the central artery underground, you've got $10 billion being pumped through this economy through a period of 10 years, about 85% federal and 15% state. So there's a multiplier effect there economically, but if you look at physically what the city will be like in another five to seven years, if it's great now you'll have basically a green belt, the harbor's already cleaner, the third harbor tunnel has already taken some of the traffic off.

Malihi: One aspect is the visible leadership of large institutions. The other aspect is the fabric of the city. When Houston went through the problems it had, people left the city. Here we didn't have college graduates who choose not to go to another city but choose to stay in this city.

Robert Griffin: Boston has survived in spite of its political process here. The universities and schools have generated jobs and the quality of life here in Boston has made people reluctant to leave. How many people do you know who have come from New York or different parts of the country and stayed here? You've got a place like MIT which is creating companies.

Aertsen: If you looked at the people who came out of Harvard and MIT and created the mini-computer wave and a lot of the technology companies that grew up in the '60s and '70s that now populate 128, it doesn't take a lot of entrepreneurial businessmen to create a huge amount of economic vitality. We do have a very substantial share of those people who come from all over the world to go to school here and even if only a relatively small portion stay, their impact on the economy is tremendous. We see that in this wave of company startups. Today I don't know that we have the total advantage that we had in the '70s and '80s, I think there are a lot of other regions that are getting the benefit of the people who are going to school here including people who come from Asia and Latin America who come to go to school here and then go back. But we're still a good share as witnessed by the incubator locations like Cambridge and other places on 128.

There's a cyclical impact that everyone sees in the economic recovery of real estate in Boston, but there's some longer term secular issues that I think are there too. There's a cyclical improvement in rents, and perhaps a secular one where you have a migration away from industrial companies and into office, because industrial is more or less flat. You have the demographic inflow into the city witnessed by older people whose kids have grown up moving into the city which may be why you're getting a lot of pressure in part on the residential properties. Retailing with the box stores might be suggestive, particularly in the suburban areas, of the eroding purchasing power because manufacturers are moving out and a lot of this economic development inside 495. What are these long-term trends suggesting for us, and is the cyclical wave of increase masking some longer term issues?

We do a lot of demographic work at Bank of Boston in real estate with David Birch's database (Cognetics) because he tracks the purchasing power in the economy through the private sector workforce. He `s pointing to this slow, imperceptible day-to-day, but still sort of glacial-like migration from the north to the south and from east to west when it comes to manufacturing-type activities. This is a long-term trend. Plus the demographics of the baby boomers getting older, retiring women in the workforce having less of an impact. All of these things need to be looked at very hard and not to get wound up in just the short-term, near-term cyclical issue of what's happening with no new construction and lots of demand for space.

Q: Are there any factors in the market that could lead to a downturn?

Forbes: In the short term, a helluva drop in the stock market could raise some problems in the market. It's interesting about what you were saying about fragmentation, because it does create a more democratized business community and I think that's very healthy. But the other side of it, and I see this worldwide, seems to be that we can develop into this sort of experienced people with have the skills that they need to progress and opportunities, and then a pool of people in droves who are dropping out. And Boston has a share of that pool, the haves and the have-nots. And I don't know what can be done, but as that migration that Birch refers to goes out, those jobs become fewer and fewer, or certainly not in any way able to keep someone on the ladder. And I worry about that. In the long run the risk is that Boston will always have a top tier and a strength, but will it have opportunities that will keep a stable, basically lower class from getting so frustrated with the situation like in the '60s. We have to be cognizant of that. The day that people don't see that opportunity, the system will change dramatically.

Collins: One of the things we haven't talked about is the move toward the international markets. Cushman & Wakefield did a study recently in which they polled a bunch of CEOs and CFOs and talked about where their operations are today, and most of their operations are in the United States, but when they asked them where they were going to be expanding, the us and Western Europe weren't even on the list. It's all Third-World countries. Everybody's trying to move their businesses closer to the growing markets and the growing markets aren't in the United States or in Western Europe.

So if you look at manufacturing jobs, we've been losing those jobs since the middle of the 1800s. That's going to continue, but are we in an industrial revolution or a technology revolution? I think we're in a technology revolution, and I think Stewart's point is well taken. We have to have a balanced society.

Q: How does the lack of planning and outrageous business growth for the gazelle companies impact the Boston office market? Are they taking up the sublet space on the market? Is it changing lease terms? Is flexibility the rule of the day.

Malihi: All of the above. We're in an industry where we're supposed to listen to our customers. The customer that you just described, who happens to be a good size of the market, wants a product that's fundamentally different than what Bank of Boston wants or the large institutions. They generally don't have much credit, they have no clue as to whether they're going to be around two years from now or at five times the size. So we need to get back into real estate for them rather than credit arbitrage. The startup companies will pay a premium for flexibility and at the end of the day I don't know what a 10-year term means to a company that was born six months ago.

McCall: We are arguably in a more mature phase of the industry lifecycle. Commercial real estate is going to grow in the 1% to 2% range and the economy's going to grow 2% to 3%. Demand for commercial real estate is going to grow at a substantially slower pace than has been true for pretty much most of the post-World War II era. If you're a real estate owner or operator the game is not to just get a share of a rapidly increasing pie, the game is now stealing market share from the other guy because the pie isn't growing very quickly. In the real estate business you have to be more sophisticated. You can do it by paying more attention to your customers. You can also do it by using the real estate capital markets which have evolved dramatically in the last five years. Ten years from now we will have a much more concentrated real estate industry than we have today. You need look no further than the regional mall industry to see what's going on there. Scale helps address some of the issues that Mahmood was just alluding to. We're at a fork in the road for real estate operators now as the markets are recovering. One fork is called customer loyalty or franchise value. The other fork is called landlord's revenge. Which path you take will define whether you're a winner or a loser.

Griffin: A third fork is that people are going to have to be market timers. This is a cyclical business and I'm not sure critical mass in any one area is going to be as important as understanding where we are in these various cycles. The cycles are going to be much less forgiving than they have in the past because there's this herd mentality of investing that goes on. Retail malls are the perfect example. Three years ago everybody wanted to own retail malls and power centers. Now nobody wants to touch them. Everybody wants to own suburban office buildings. At some point, people are going to sell off of that, and once enough people start to look down on office that sector's going to get hurt again because we've gone right back to the 1980s in terms of how people are underwriting these assets.

David Fitzgerald: Do you see where, particularly with the owners of real estate, where you begin facing different branding issues that clearly you don't do now? There are no real estate owners that are recognized by people who go down the street and say, `Oh, there's the Marriott."

McCall: The issue is who controls the action at the margin. Today, people who never even thought about Beacon are looking over their shoulder saying, `Why didn't Beacon bid on that?'

Griffin: I would politely disagree with you. We handle a lot of dispositions and people aren't looking over their shoulder at REITs. If there are 10 or 11 offers on the table, Beacon might be 11th. If we do $1.5 billion in trade this year in Boston, Beacon may have 5% or 10% of that market.

McCall: Property will be held by a hugely fragmented market of owners for a long, long time. But the mindset among pension funds is they can't stand owning assets. But the trend toward a larger REIT industry and consolidation is really underway. We just got an assignment to help CalSTERS to securitize $1.7 billion in directly held real estate. They want to swap it into public REITs. That sends a big ripple through the marketplace.